Co-written by Kristina Maestas
SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) may be the worst bond strategy of all time.
Now that we have your attention, let’s break down the major issues with junk bonds, and more specifically with ETFs that trade baskets of those bonds. Don’t worry, there is a place for these ugly ducklings, but they are not for those trying to get fixed income risk and return. If that doesn’t keep you reading, nothing will.
The junk bond market, developed by Michael Milken in the 1980s, is predominately a U.S. phenomenon, though they exist anywhere there is tradable debt. Simply stated, they are bonds with a poor rating. Most notable, junk bonds have higher credit risk and illiquidity, but also higher interest payments (as long as they keep paying). We want to cover the problem with junk bonds within a portfolio, the true cost of owning them, and how investors should approach the junk bond market. As a warning, most investors should simply stay away. That doesn’t mean they don’t have a place, but like many niche markets the application is small compared to the heard of stockbrokers touting them.
There is something to be said about junk bonds and those who invest in them. Often our firm encounters clients and potential clients that ask if we invest in junk bonds. Our first reaction is to question why they are interested. Usually investors see high yields as a magic bullet providing return and no risk. After all, it’s a bond, right?
Some clients are savvy enough to see it as a potential play on improving credit risk, which can lead to capital appreciation if properly timed. Unfortunately, not all ugly ducklings will turn into beautiful swans. The best opportunities involve the worst of the worst junk bonds, are illiquid, and end up as the hunting ground of the best hedge fund managers in the world; not exactly the place for main street investors. Plus, the real trash is not available via your online broker. From a practical level, the cost of trading, minimum size, and research to do it right is highly specialized.
Adding to the problem of incorporating junk bonds into a portfolio is the high correlation to equity markets with lower risk-adjusted returns. Over the past five years we can see a correlation to the S&P 500 of 0.626. This is not bad, and some would say if this was for an equity basket, it is better than the 0.9 correlation with the MSCI Emerging Markets Index. However, when you match that with raw annual volatility of 21% versus 25% for the S&P 500, you just don’t get a big enough bang for your buck to compensate for the risk.
Let me put these simple stats into English. Junk bonds via JNK have risk similar to equity markets, marginal diversification capabilities, and performance that is, at best, mediocre.
If you still want to invest, which we do in certain situations, keep reading. It gets worse.
Let’s look at the easiest way to approach the junk bond market: The ETF that tracks the Barclays High Yield Very Liquid Index. Whoa, did you notice that? What is a "very liquid" index and, what happened to the not-so-liquid index?
There is no such thing as the S&P 500 very liquid index. Remember that many junk bonds started life as decent debt, but turned into dogs over the years. In order to have something that can be bought and sold each day, you need the most liquid of the dogs. The problem is that, relative to better quality bonds, liquid junk still trades like sludge.
Why is this a problem? Tracking error. This is the divergence of a basket like an ETF from the benchmark it follows like the Barclays index. Remember that you can’t invest in any index directly; indexes are just a mathematical calculation based on a group of securities. When you actually go and buy the stuff, your results will be different.
Highly liquid securities don’t have an issue. For example, SPDR S&P 500 (NYSEARCA:SPY) tracks the S&P 500. So how well has that ETF done tracking this index over the years? Year to date, SPY almost exactly matches the cash index. In one year, there was a delicate tracking error from the benchmark of 0.21%. In the last three years, this error was only 0.02%, and since 2006 only 0.05%. Since inception it has only been off by 0.01%.
The people who put SPY together deserve some credit for that performance. Year-to-date, JNK has already diverged by 0.05%. This grows to 1.08% and 4% in the last year and last three years respectively. Since its inception in 2007, the tracking error for JNK is 4.06%. Now that is significant tracking error!
And the tracking error is not because the people at SPDR don’t have a grasp on tracking indexes. If you run the numbers from junk bonds, to investment grade corporates, to highly liquid U.S. Treasuries, you will see an almost linear decline of tracking error. Just look up the errors of JNK, LQD, BND, and SHY.
If this stuff is so bad, then why does anyone invest in the sector? Most should not, but our firm has a single example of their use. Keep in mind there are many other reasons to be long or short the group, but we find most individual investors use them for all the wrong reasons. There are certain types of irrevocable trusts that dictate how the beneficiary gets paid. For example, you may be the beneficiary of a trust, but only get the interest and any paid out dividends. The principle stays in the trust and goes to somebody else, usually after you are below ground.
We have set up some portfolios to be higher in interest income, while accepting the risk of the broad equity markets. While this may not be the most efficient portfolio, proper risk management and low internal fees can achieve higher interest than straight stock. This is not for everybody, and each account needs careful attention. The bottom line: there is a reason for junk bonds, but the level of care needed to harness their unique qualities requires close monitoring. Be careful out there.
Disclosure: I am long BND, SHY, HYG.